Exchange Rate Shocks and Inflation Co-movement in the Euro Area

Abstract

This paper decomposes the time-varying effect of exogenous exchange rate shocks on euro-area countries' inflation into country-specific (idiosyncratic) and regionwide (common) components. To do so, we propose a flexible empirical framework based on dynamic factor models subject to drifting parameters and exogenous information. We show that exogenous shocks are behind an important share of nominal EUR/USD fluctuations over the recent years. Our main results indicate that headline inflation in euro-area countries has become significantly more affected by exchange rate shocks since the early 2010s. While in the case of headline inflation this increasing sensitivity is solely reliant on the idiosyncratic component, for energy inflation it is based on both idiosyncratic and common components. By contrast, exchange rate shocks do not seem to have a significant impact on the core component of headline inflation.